How Changing Interest Rates Affect Bonds | U.S. Bank (2024)


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How Changing Interest Rates Affect Bonds | U.S. Bank (1)

Key takeaways

  • U.S. Treasury yields have trended higher in 2024.

  • Yields on the benchmark 10-year U.S. Treasury started the year below 4%, but in early April moved above 4.5%.

  • Bonds in the current environment appear to offer investors more attractive long-term opportunities.

With the timing of anticipated Federal Reserve (Fed) interest rate cuts in question, bond yields trended higher – within a modest range – for much of the year. In early April, yields on the benchmark 10-year U.S. Treasury note jumped up, moving 0.2% higher in a single day.

“Economic growth remains solid, which might indicate interest rates need to remain elevated for some time,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “The most recent data indicates inflation may linger higher for longer, and we’re also seeing foreign buyers stepping back from the U.S. market. Both factors contribute to keeping bond yields higher as well.”

The yield on the 10-year U.S. Treasury started the year at 3.88%, but moved to 4.55% in early April.1 The latest jump occurred in the wake of a government report showing that inflation, for the 12-month period ending in March 2024, rose to 3.5%, its highest level since September 2023.2 After topping out at 4.98% in October 2023, 10-year Treasury yields dropped below 4%, but have trended higher over the course of 2024, with modest up-and-down-movements.1

How Changing Interest Rates Affect Bonds | U.S. Bank (2)

The bond market in 2024 continues to exhibit topsy-turvy dynamics, with yields on short-term bonds exceeding those of longer-term bonds. For example, as of April 10, 2024, 3-month Treasury bills yielded 5.45% and 2-year Treasury yields were 4.97%, compared to the 4.55% yield on the 10-year Treasury.1 The Fed is keeping the door open to potential federal funds target rate cuts later in the year, but the latest inflation data may push the timeline for the start of Fed rate cuts further out.

The current bond yield environment emerged after the Fed began raising the short-term interest rate it controls – the federal funds rate – in early 2022. Between March 2022 and July 2023, the Fed raised rates eleven times, from near 0% to an upper range of 5.50%. Since then, the Fed has held the line on further rate hikes and indicated that it will eventually begin cutting rates in 2024, reversing its previous policy.

“If the Fed cuts short-term interest rates, yields on shorter-term debt issues are likely to decline,” says Haworth. “The current upward movement we’ve seen in bond yields reflects markets getting well ahead of expectations for 2024 Fed rate cuts,” says Haworth. At recent meetings of the policy-making Federal Open Market Committee (FOMC), the indication was that three cuts would occur in 2024. “The markets, however, appeared to anticipate many more 2024 rate cuts, and long-term bond yields began to drop in late 2023 as a result.” says Haworth. “Now the reality set in that the Fed is maintaining higher rates for longer than the markets initially anticipated.” That resulted in the recent upward movement in bond yields.

What should investors expect from the bond market for the remainder of the year and what does that say about how to incorporate or adjust strategies for fixed-income investors?

Changing bond market

Despite the recent decline in bond yields, they remain significantly higher than was the case at the start of 2022. “Three key factors drove the jump in bond yields,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. “First is the Fed’s policy response to inflation. Second is the strength of the U.S. economy. Finally, there is an increasing supply of U.S. Treasury securities coming to the market.”

“Money sitting in cash loses purchasing power every day that inflation rates stay above zero. Investors with a low tolerance for risk can offset the impact of inflation on their purchasing power, and in the current environment, grow their purchasing power, by owning bonds with a range of maturities,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management.

“New Treasury bond issuance is growing due to a combination of federal government deficit spending that must be funded and the higher interest costs associated with today’s elevated interest rates,” says Merz. At the same time issuance is up, the Fed, as part of its monetary tightening policy, began allowing its large portfolio of U.S. Treasuries and agency mortgage-backed securities to mature. “That means other investors need to absorb the growing Treasury supply,” says Merz.

Haworth believes the Fed may need to reconsider its policy of reducing its balance sheet of Treasury debt given the federal government’s need to expand Treasury issuance to cover budget shortfalls and other funding priorities. “It may need to hit the brakes on its balance sheet reduction at some point in the future,” says Haworth.

Inverted yield curve persists

The yield curve, representing different bond maturities, has persistently remained inverted since late 2022. Under normal circ*mstances, bonds with longer maturity dates yield more, represented by an upward sloping yield curve (as in the line on the chart representing the yield curve on 12/31/21). It logically reflects that investors normally demand a return premium (reflected in higher yields) for the greater uncertainty inherent in lending money over a longer time. Many yield curve pairs using various maturities have been inverted since late 2022. This is due in large part to the Fed’s rate hikes, which have the greatest direct impact on short-term bond yields.

How Changing Interest Rates Affect Bonds | U.S. Bank (3)

Haworth notes that in recent months, the inverted curve has flattened a bit. “Yields are still higher on one-month to two-year Treasuries, but the curve is relatively flat from the five-year level on up.” Haworth says a major question is how the inverted yield curve scenario is resolved. “If shorter-term yields come down to normalize the curve, it will reflect the Fed achieving its inflation-fighting goals. If the curve normalizes because long-term rates go higher, it likely means inflation remains elevated, which results in other challenges for the Fed and investors.”

Keeping an eye on the Fed

The Fed’s rate hikes were designed to slow the economy as a way to reduce inflation, which peaked at 9.1% for the 12 months ending June 2022, but dropped to 3.1% by January 2024. However, March’s 3.5% inflation raises concerns that the inflation fight is far from over.2

In the meantime, markets are keeping a close eye on the timing of the first Fed rate cut. “When the Fed decides to do so, its focus will be less on stimulating the economy than on gradually loosening its monetary policy to return to a more neutral position,” says Haworth. “But we will need to see a number of rate cuts to reach a “neutral” fed funds rate, which the Fed indicates is 2.5%.” This compares to the current fed funds target rate range of 5.25% to 5.50%.

Finding opportunity in the bond market

How should investors approach fixed income markets today? “Money sitting in cash loses purchasing power every day that inflation rates stay above zero,” says Merz. “Investors with a low tolerance for risk can offset the impact of inflation on their purchasing power, and in the current environment, grow their purchasing power, by owning bonds with a range of maturities.”

Despite the appeal of short-term bonds paying higher yields, Merz says investors with a long-term time horizons are well served by building diversified portfolios designed to generate competitive returns over time. “It’s time to take money that was shifted away from appropriate bond allocations during the period of historically low interest rates to gradually move money into longer-term bonds. Longer-term bond yields remain far more compelling today than they have been in years.” Merz says for conservative investors, “It’s possible to generate reasonably attractive returns in a mix of bonds without extending their risk budget.”

Additional opportunities exist depending on investors’ risk tolerance and tax situation. For example, investors in high tax brackets may benefit from extending durations slightly longer and including an allocation to high-yield municipal bonds as a way to supplement their investment grade municipal bond portfolio. Certain non-taxable investors may benefit from diversifying into non-government agency issued residential mortgage-backed securities. They can also incorporate long-maturity U.S. Treasury securities to manage total portfolio duration. And insurance-linked securities may offer a way to capture differentiated cash flow with low correlation to other portfolio factors for certain eligible investors.

Talk to your wealth professional for more information about how to position your fixed income investments as part of a diversified portfolio.

Frequently asked questions

The bond market is often reflective of other key factors that affect the economy. If the economy grows rapidly and inflation is rising, bond yields tend to follow suit. Bond yields also tend to rise if the Federal Reserve, the nation’s central bank, raises the short-term interest rate it controls, the federal funds rate. Inflation in the U.S. began surging in 2021, and by early 2022, the Federal Reserve began raising rates. As a result, yields across the bond market began rising. In contrast, if the economy is slowing or maintaining modest growth with low inflation, bond yields tend to decline or remain low. This was the situation for an extended period prior to 2022.

Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value. The change in bond values only relates to a bond’s price on the open market, meaning if the bond is sold before maturity, the seller will obtain a higher or lower price for the bond compared to its face value, depending on current interest rates. Bondholders will generally be repaid the face value of a bond if it is held to maturity, regardless of the interest rate environment.

There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels. However, even when interest rates are low, bonds can still be appropriate for inclusion in a well-diversified portfolio.


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How Changing Interest Rates Affect Bonds | U.S. Bank (2024)


How Changing Interest Rates Affect Bonds | U.S. Bank? ›

Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher.

What happens to bonds when interest rate changes? ›

When the Fed increases the federal funds rate, the price of existing fixed-rate bonds decreases and the yields on new fixed-rate bonds increases. The opposite happens when interest rates go down: existing fixed-rate bond prices go up and new fixed-rate bond yields decline.

How does rising interest rates affect banks? ›

As interest rates rise, profitability on loans increases, as there is a greater spread between the federal funds rate that the bank earns on its short-term loans and the interest rate that it pays to its customers. In fact, long-term rates tend to rise faster than short-term rates.

Are bank bonds safe? ›

All bonds carry some degree of "credit risk," or the risk that the bond issuer may default on one or more payments before the bond reaches maturity. In the event of a default, you may lose some or all of the income you were entitled to, and even some or all of principal amount invested.

What factors affect bond value as market interest rates change? ›

Essentially, the price of a bond goes up and down depending on the value of the income provided by its coupon payments relative to broader interest rates. If prevailing interest rates increase above the bond's coupon rate, the bond becomes less attractive.

Why do banks lose money on bonds when interest rates rise? ›

What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.

Will bonds go up if interest rates rise? ›

Bond prices have an inverse relationship with interest rates. This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up.

Do banks lose money when interest rates rise? ›

Banks, brokerages, mortgage companies, and insurance companies' earnings often increase—as interest rates move higher—because they can charge more for lending.

Why are banks more profitable when interest rates rise? ›

Rising interest rates can influence bank profitability positively (by increasing payments from those with floating-rate debt) or negatively (by forcing banks to offer higher returns to their depositors).

What is interest rate risk in bonds? ›

Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investment: As interest rates rise bond prices fall, and vice versa. This means that the market price of existing bonds drops to offset the more attractive rates of new bond issues.

What is the safest bank bond? ›

Treasuries are generally considered"risk-free" since the federal government guarantees them and has never (yet) defaulted. These government bonds are often best for investors seeking a safe haven for their money, particularly during volatile market periods. They offer high liquidity due to an active secondary market.

How much is a $100 savings bond worth after 20 years? ›

How to get the most value from your savings bonds
Face ValuePurchase Amount20-Year Value (Purchased May 2000)
$50 Bond$100$109.52
$100 Bond$200$219.04
$500 Bond$400$547.60
$1,000 Bond$800$1,095.20

Do you ever lose money on bonds? ›

Key Takeaways

Bond prices decline when interest rates rise, when the issuer experiences a negative credit event, or as market liquidity dries up. Inflation can also erode the returns on bonds, as well as taxes or regulatory changes.

Can you lose money on bonds if held to maturity? ›

After bonds are initially issued, their worth will fluctuate like a stock's would. If you're holding the bond to maturity, the fluctuations won't matter—your interest payments and face value won't change.

Should I buy bonds when interest rates are high? ›

Investing in bonds when interest rates have peaked can yield higher returns. However, rising interest rates reward bond investors who reinvest their principal over time. It's hard to time the bond market. If your goal for investing in bonds is to reduce portfolio risk and volatility, it's best not to wait.

Will bond funds recover in 2024? ›

As for fixed income, we expect a strong bounce-back year to play out over the course of 2024. When bond yields are high, the income earned is often enough to offset most price fluctuations. In fact, for the 10-year Treasury to deliver a negative return in 2024, the yield would have to rise to 5.3 percent.

Is it better to buy bonds when interest rates are high or low? ›

When rates go up, bond prices typically go down, and when interest rates decline, bond prices typically rise. This is a fundamental principle of bond investing, which leaves investors exposed to interest rate risk—the risk that an investment's value will fluctuate due to changes in interest rates.

How much is a $100 savings bond worth after 30 years? ›

How to get the most value from your savings bonds
Face ValuePurchase Amount30-Year Value (Purchased May 1990)
$50 Bond$100$207.36
$100 Bond$200$414.72
$500 Bond$400$1,036.80
$1,000 Bond$800$2,073.60

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